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11 - 32 A Macroeconomic Theory
11 - 32 A Macroeconomic Theory
11 - 32 A Macroeconomic Theory
32
A Macroeconomic Theory
of the Open Economy
Economics
PRINCIPLES OF
N. Gregory Mankiw
1
Introduction
▪ The previous chapter explained the basic
concepts and vocabulary of the open economy:
net exports (NX), net capital outflow (NCO),
and exchange rates.
▪ This chapter ties these concepts together into a
theory of the open economy.
▪ We will use this theory to see how govt policies
and various events affect the trade balance,
exchange rate, and capital flows.
▪ We start with the loanable funds market…
A MACROECONOMIC THEORY OF THE OPEN ECONOMY 2
The Market for Loanable Funds
▪ An identity from the preceding chapter:
S = I + NCO
Saving Net capital
Domestic
outflow
investment
D = I + NCO
LF
2%
1%
0%
-1%
-2%
-3% U.S. net exports
-4%
-5%
1995-2000
1986-90
1991-95
1981-85
2001-05
1976-80
1961-65
1966-70
1971-75
SUMMARY: The Effects of a Budget Deficit
r1 r1
D NCO
LF NCO
A MACROECONOMIC THEORY OF THE OPEN ECONOMY 19
Analysis of a Quota on Cars from Japan
Since NCO unchanged, Market for foreign-
S curve does not shift. currency exchange
The D curve shifts: E S = NCO
At each E,
imports of cars fall, E2
so net exports rise,
D shifts to the right. E1
At E1, there is excess D2
demand in the foreign
D1
exchange market.
E rises to restore eq’m. Dollars
r2 r2
r1 r1
D2 NCO2
D1 NCO1
LF NCO
A MACROECONOMIC THEORY OF THE OPEN ECONOMY 25
Capital Flight from Mexico
Market for foreign-
The increase in NCO currency exchange
causes an increase in
E S1 = NCO1
the supply of pesos in
the foreign exchange S2 = NCO2
market.
The real exchange rate E1
value of the peso falls.
E2
D1
Pesos
0.10
0.15
0.20
0.25
0.30
0.35
10/23/1994
11/12/1994
12/2/1994
12/22/1994
1/11/1995
1/31/1995
2/20/1995
3/12/1995
4/1/1995
Examples of Capital Flight: Mexico, 1994
US Dollars per currency unit.
1/1/1997 = 100
0
20
40
60
80
100
120
12/1/1996
2/24/1997
5/20/1997
8/13/1997
11/6/1997
1/30/1998
4/25/1998
Thai Baht
Examples of Capital Flight: S.E. Asia, 1997
Indonesia Rupiah
7/19/1998
South Korea Won
US Dollars per currency unit .
0.00
0.04
0.08
0.12
0.16
0.20
5/5/1998
6/14/1998
7/24/1998
9/2/1998
10/12/1998
11/21/1998
Examples of Capital Flight: Russia, 1998
12/31/1998
U.S. Dollars per currency unit .
0.0
0.2
0.4
0.6
0.8
1.0
1.2
7/1/2001
9/19/2001
12/8/2001
2/26/2002
5/17/2002
8/5/2002
10/24/2002
1/12/2003
Examples of Capital Flight: Argentina, 2002
CASE STUDY: The Falling Dollar
U.S. trade-weighted nominal exchange
90 rate index, March 1973 = 100
From 10/2005
85
to 6/2008,
the dollar
80
depreciated
17.3%
75
70
65
2005 2006 2007 2008 31
CASE STUDY: The Falling Dollar
Two likely causes:
▪ Subprime mortgage crisis
▪ Reduced confidence in U.S. mortgage-backed
securities
▪ Increased NCO
▪ U.S. interest rate cuts
▪ From 7/2006 to 7/2008, Federal Funds target
rate reduced from 5.25% to 2.00% to stimulate
the sluggish U.S. economy.
▪ Increased NCO
A MACROECONOMIC THEORY OF THE OPEN ECONOMY 32
CONCLUSION
▪ The U.S. economy is becoming increasingly
open:
▪ Trade in g&s is rising relative to GDP.
▪ Increasingly, people hold international assets in
their portfolios and firms finance investment with
foreign capital.
37